The Tory price cap: what do we know? UPDATED

17/05/2017

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A definitive commitment to energy retail price regulation from Theresa May has sent shockwaves through the industry, and its investor base. What lobbying positions and strategies should suppliers now adopt?

The manifesto is out. The wondering about the final and official wording of the Conservative price cap pledge for the energy retail market is at an end.

As expected, a price cap or “safeguard tariff” has been explicitly promised – and there’s no harbour for the sector with the Opposition. Labour would go further, capping bills at £1,000 per annum and re-introducing elements of nationalisation across both energy supply and distribution as well as water.

In the run up to the publication of the party manifestos, these pledges to intervene with “tough” and “muscular” action to fix a “dysfunctional” and “abusive” utility market inevitably sparked uproar in the industry.

The Tory pledge in particular is felt by the business community as a betrayal of its traditionally pro-market ideology. Given the state of the polls in the lead up to 8 June, it is also the commitment with most chance of transferring to reality.

But however outraged leaders may be, the time now is not for public indignation. It is for scenario planning and damage limitation.

Doing this effectively relies on companies’ ability to understand the possible shapes that a price cap might take, within the scope that the manifesto has set out, and then selecting a least wort option to back.

So, what might a Conservative price cap to support “ordinary working families” look like? When might it come into effect? And how long might it remain in place

The manifesto gives us some clues to flesh out the speculation which has been rampant in the energy industry in recent months.

The prime minister has committed to introduce a “safeguard tariff to protect energy customers from unacceptable price rises” but her wording tells us that there may be some room for negotiation regarding how far this tariff extends.

The proposed price regulation will “extend the price protection currently in place for some vulnerable customers [the prepayment meter cap] to more customers on the poorest value tariffs.”

While this might still mean a whole market cap for all SVT customers, a subsequent manifesto commitment to “maintain the competitive element of the retail energy market by supporting initiatives to make the switching process easier and more reliable” suggests Ofgem – which will do government’s dirty work in delivering the cap – has room for manoeuvre.

This news should be welcomed by suppliers. Citizens Advice has long advocated an extension of the prepayment price cap to other vulnerable customer types, including those in receipt of the warm homes discount, and trade body Energy UK has recently rallied behind them, saying a cap should only apply to those who really need it.

Of course, there are still questions to be answered about the way either a partial or all-SVT cap would be set. Would it adhere to a high bar price? Or will Ofgem choose to stick with its prepayment meter methodology of a six-monthly “crawling peg”? (See analysis below for more).

"Centrica’s famous weighted average cost of gas (WACOG) acronym could also make a welcome re-appearance under price regulation." See more in Nigel Hawkins analysis below...

There will also still be concerns about the unintended consequences that a cap of any sort will have on competition.

Centrica’s Iain Conn has been among the most forthright of industry leaders in setting out his belief that: “Price regulation will result in reduced competition and choice, stifle innovation and potentially impact customer service. This will negatively impact consumers.”

If forced to pick a lesser of two evils however, retailers would be wise to champion a targeted approach to capping, and without that, to communicate tirelessly to government, its efforts to make the rest of the market a place that “works for everyone”, echoing the new Tory mantra wherever possible in marketing, briefing sessions and more.

The prime minster, could be shy of siding with a partial market cap for fear of being slated for watering down more robust language used in the past. But if she wins the storming majority anticipated by pundits, she might not worry about such mithering as long as she is confident her mandate is being delivered.

Once Theresa May signs off an approved structure for the cap, the next questions for suppliers are how quickly will it be adopted, and when will it expire?

We know the Tories expect Ofgem to design and police the cap. And we know that delivering a new market model will take the regulator time. Experts like Ryan Thomson, a partner at consultancy Baringa, believe Ofgem will need a minimum of one year to develop and scrutinise its plans for introducing a cap. “I think there is a good chance of it pushing towards a two-year period for full implementation,” he tells Utility Week.

By the time implementation is complete, it’s more than likely “the industry will have moved on” Thomson opines. As for the cap’s duration, he suggests that rather than imposing an arbitrary time limit on the cap, it would make more sense for government and Ofgem to agree a set of conditions which would need to be met by the market before the cap is withdrawn.

"A note from the utilities equity research team at Barclays suggests that margins will be squeezed at the big six but that they will remain profitable." See more in David Blackman's analysis below...

Not all energy market participants are gloomy about the prospect of price regulation. Some, like Bristol Energy’s Peter Haigh, hope that a price cap brought to market in “a timely way” and with “robust” performance measures, will throw down “a gauntlet to the big six”. Stephen Fitzpatick, chief executive of fellow Bristol-based supplier Ovo Energy has stridently welcomed May’s move as a “bold and audacious” answer to a long failure of “light-touch regulation”.

He insists a cap on SVTs “will set a ceiling on retail prices based on underlying market conditions, allowing headroom for efficient companies to operate profitably.”

There’s no denying however, that investors at large firms are jumpy. Their dividends are now in uncertain territory and earnings at the big six are expected to be slashed by hundreds of millions of pounds as a result of price regulation.

Centrica and SSE, with the healthiest profit margins of the big six, may just be able to bob along in the black under price regulation. Barclays has run some figures which suggest the firms could expect 2.5-3 per cent profits. But other firms have little or no headroom.

Executives will need to do all they can to assure shareholders that internal efficiencies are as strong as they possibly can be while revenues are squeezed and policy costs rise. They will also need to show they are working closely with government and Ofgem to tie a non-lethal noose for their necks.

Giving with one hand…

While the wording of the Conservative manifesto pledge on domestic energy price capping has slightly buoyed the spirits of gloomy executives at large energy suppliers, another element of the document has etched a new furrow in their brows.

In addition to extending protections to more struggling domestic customers, the manifesto says a Conservative government would consult on how to bring microbusiness customers into scope.

It’s not a twist many retail leaders were expecting and it could be a concerning one.

Jane Gray, deputy editor, Utility Week

Analysis

Theresa May has sent a hospital pass over to Ofgem by delegating responsibility for the delivering her price cap. How will the regulator recieve it?

The decision to impose a price cap on domestic energy prices is now central to the Conservative party manifesto. This is now clear, despite cries of frustration from the political left, who say the Tories have stolen their thunder by rebranding the proposals of former Labour leader Ed Miliband, and opprobrium from the right for the policy being both anti-competitive and non-Conservative.

As for the utility companies, their criticism has been near universal.

Nevertheless, Theresa May’s fury with energy companies – and her response to numerous price rises of late – issues a hospital pass to Ofgem, which will be responsible for implementing her mandate on price regulation.

Of course, the policy may be watered down or even abandoned, especially if the government is re-elected with a landslide majority. But assuming it forges ahead, there are four leading methodologies Ofgem could choose to adopt.

1. It could set a seemingly notional high-bar figure and threaten any company seeking to breach it with heavy fines: the aim would be to dissuade any supplier from even going there. This option should also compress the price range that individual companies offer under various tariffs.

2. Ofgem could prescribe a “crawling peg” system, which would be adjusted, say every six months, to reflect changing purchasing prices. All companies would be expected to offer prices around the crawling peg figure.

4. Ofgem could go the whole hog and seek to emulate the water sector by applying the Full Monty of regulatory tools.

Centrica’s famous weighted average cost of gas (WACOG) acronym could also make a welcome re-appearance under price regulation. For commercial sensitivity reasons, it was struck out of Centrica’s investor presentations.

Theoretically, every licensed energy supplier could be required to publish an audited WACOG figure on a regular basis in a capped market.

In the short term, options 1 and 2 look the most likely, although neither of the latter options should be discounted as a last resort.

Nigel Hawkins, director, Nigel Hawkins Associates

Analysis

Industry pleads for a targetted cap

Labour’s pledge to bring energy back into public ownership, outlined in the party’s leaked manifesto, could prove popular with the public. A poll conducted by the Daily Mirror shows that nearly half (49 per cent) support the policy with around a quarter (24 per cent) opposed.

However with the Conservatives maintaining a lead of at least 11 per cent, according to the latest polls (check prior), the opposition’s proposals are likely to be of interest only to students of doomed election manifestos.

The energy sector seems to have made this calculation, judging by the volume of responses to the two parties’ proposals. While the Tories mooted cap provoked a flood of responses, Labour’s more radical package has generated barely a murmur.

The bulk of the big six have fallen solidly into line behind the stance adopted by Energy UK, which has warned that the Tories’ cap won’t deliver the savings that the government wants to achieve.

Rather than a broad-brush intervention across the whole of the market, help should be focused on helping those who really need it, says the energy trade body. Capping prices will also mean companies have less scope to undercut the headline standard variable tariffs, which will kill off competition in the market, ultimately resulting in the perverse consequence of higher prices.

This script is backed up by the comparison websites, which of course have a vested interest in encouraging switching. They also back the big energy companies’ argument that the proposed remedies in last summer’s Competition and Markets Authority retail energy market report, which focused on encouraging customers to switch, should be given more time to work.

Some energy companies have though lined up alongside the government.

Scottish Power CEO Keith Anderson is beating his own drum, insisting that SVTs should be scrapped altogether and Stephen Fitzpatrick, his counterpart at challenger utility OVO Energy, defends the cap as sufficiently flexible to enable suppliers to continue competing with one another.

A note from the utilities equity research team at Barclays suggests that margins will be squeezed at the big six but that they will remain profitable. Barclays calculates that margins on an EBIT (earnings before interest and taxes) basis of 2-3 per cent are feasible.

For Centrica and SSE, margins would drop from 4 per cent to 3 per cent and 2.5 per cent respectively. Provided both companies can make efficiencies, margins will recover to 4-4.5 per cent by 2023, Barclays forecasts.

Lower margins will though mean less cash available for investment in the low carbon energy infrastructure to replace the coal burning stations that the government is still committed to phasing out.

Nevertheless, having stuck her colours so firmly to the mast on energy price caps and despite Tory grassroots grumblings that a Conservative government has no business controlling energy prices, May is unlikely to be for turning.